99-023 Response March 27, 2000

99-023

Response March 27, 2000

REQUEST LETTER

March 9th 1999

Via Registered Mail

NOTE: THIS LETTER CONSTITUTES A FORMAL REQUEST FOR AN ADVISORY OPINION TO DETERMINE WHETHER A USE TAX SHOULD APPLY TO THE PURCHASE OF CERTAIN SOFTWARE AND THE SERVICES PROVIDED AND RELATED THERETO.

Dear Mr. Chapman;

I have been retained by COMPANY. ("COMPANY@), to help determine whether a Utah use tax should apply to COMPANY=S purchase of software and related Services from COMPANY B ("COMPANY B"), a STATE company.

Issue: Is the computer software Acanned" or Acustom@ for purposes of Utah Rule R865-19S-92?

STATEMENT OF FACTS AND REASONS

I. Background of COMPANY. COMPANY. is a Utah Corporation (COMPANY) established in 1990 to provide dental benefits, plans, and insurance to families, companies, and individuals in Utah. Today, COMPANY has more than ##### participants IN PLACE, enrolled in its dental plans. Company is a technologically progressive company and is currently expanding. In the past, as COMPANY has expanded, it has hired more employees and it currently employees ##### people full time, at its office in CITY, Utah.

II. Background of COMPANY B (ACOMPANY B@). COMPANY B (ACOMPANY B@) is a STATE company formed in 1988. COMPANY B primarily develops and sells high-end Asystem integration" software for hospitals. For example, COMPANY B could, if requested, develop software and hardware solutions for the HOSPITAL in Utah, which would allow HOSPITALS various computer Systems to integrate, or Aspeak" with each other.

III. Facts Leading to Review of Use Tax.

In 1997, COMPANY determined that in order to remain competitive it needed to purchase new hardware and software that could provide advanced and flexible billing and reporting capabilities. In the October of 1997, after an industry-wide search, COMPANY approached COMPANY B (COMPANY), of CITY STATE to discuss a product COMPANY B was then developing for dental HMOs, called "NAME" and "NAME."

Software Order. After a ten-month review and negotiation period, COMPANY B provided, at COMPANY=S request, a preliminary development and implementation quote that included hardware, software, ongoing support. After further negotiations and reviews, Dental Select signed a "Software Order" on December 31st 1998 to purchase the software at a cost of $$$$$ with a yearly maintenance and support cost of $$$$$. COMPANY concedes that it must remit any taxes related to the hardware solution portion of the quote, but maintains that the software is "custom" and not "canned" for purposes of Utah Rule R865-19S-92.

Both COMPANY B and COMPANY expect that a "live" version of the software will be installed at COMPANY=S office within the next eight to nine months.

SUMMARY OF ARGUMENTS AND AUTHORITIES RELIED UPON

I. "Custom" or "Canned" Software.

These following points, made by COMPANY B head programmer (please see the attached letter), about the

necessary modifications that must be made to the software "mirror" particular elements which, according to past Advisory Opinions issued by the Commission, are essential and determinative in deciding whether the software is 'custom" or "canned":

1. The software is not functional to COMPANY without extensive and significant modifications (including source code, rules, data conversions, mapping, and code tables).

2. COMPANY submitted a Software Order to COMPANY B on December 31, 1998 after a comprehensive ten (10) month review, negotiations and assessment period.

3. The software being provided to Dental Select is not designed and written for sale to

the general market, nor does COMPANY B inventory or mass produce the software.

4. The software solution is designed and customized to meet the particular need's of COMPANY=S dental benefits administration business.

5. The software cannot be purchased "off the shelf@ nor can it be used "out of the box,"

6. The software requires a thorough design, evaluation, modification and setup period

in order to meet COMPANY=S specific dental benefits administration needs.

7. No two clients receive the identical software or services.

8. The individual CDR that contains the software code will be replaced by COMPANY B free of charge if it is lost or stolen.

9. Without successfully completing COMPANY B training courses, COMPANY=S skilled computer personnel would be unable to load and implement any useable or live Aworking" versions of the software.

II. Conclusion and Request for Taxability Ruling.

As the previous analysis bears out, COMPANY has ordered and purchased Acustom" software from COMPANY B. The software has to have the source code "extensively and significantly" modified and, by contract, COMPANY B is required to escrow the source code in case additional modifications are needed in the future. Further, I believe that the software purchase fulfills the public policy intent of the Acustom software" exemption, through facilitating the growth and expansion of a Utah company ordering highly specialized and extensively modified software, which is essential to the growth of the business.

Therefore, based on the above representations, COMPANY respectfully requests a letter from the Utah State Tax Commission that confirms that the use tax should not apply to the software portion of COMPANY=S purchase, and the services related thereto.

Sincerely,

NAME

ATTORNEY

RESPONSE LETTER

March 27, 2000

NAME

ADDRESS

RE: Taxability of Computer Software Purchased by Dental Select

Dear NAME,

We have received your request for an advisory opinion concerning the recent purchase of computer software and related services by COMPANY B. COMPANY (ACOMPANY@) from COMPANY B (ACOMPANY B@), a STATE company. You have specifically asked whether the purchased software would be deemed Acanned@ computer software and, as a consequence, subject to sales and use tax, or if the software would be deemed Acustom@ computer software and not subject to sales and use tax.

Legal Authority. Utah Admin. Code R865-19S-92 (ARule 92") not only provides that the sale of canned computer software is subject to sales and use tax while the sale of custom computer software is not, but also distinguishes between these two types of software as follows:

A.1. "Canned computer software" or "prewritten computer software" means a program or set of programs that can be purchased and used without modification and has not been prepared at the special request of the purchaser to meet their particular needs.

A.2. "Custom computer software" means a program or set of programs designed and written specifically for a particular user. The program must be customer ordered and can incorporate preexisting routines, utilities or similar program components. The addition of a customer name or account titles or codes will not constitute a custom program.

The Utah Supreme Court has upheld such a distinction for taxation purposes, stating that the A[t]axability of programs turns on the type and amount of the personal services used in devising a computer program, in particular, whether the program is customized or not. Computer programs may be taxed, depending on whether they are Acanned@ or customized.@ Mark O. Haroldsen, Inc. v. State Tax Commission, 805 P.2d 176 (Utah 1990). The Court further explained in Haroldsen that this distinction is consistent with the Aessence of the transaction@ test. This test focuses on whether the services provided are merely incidental to an essentially personal property transaction or whether the property provided is merely incidental to an essentially service transaction. See BJ-Titan Services v. Utah State Tax Comm=m, 842 P.2d 822 (Utah 1992).

Purchase Price of the Software. You have provided the Master Software License and Services Agreement (AAgreement@) relating to COMPANY=S purchase of software from COMPANY B. Included in this Agreement are exhibits that itemize the costs of the software and services being purchased. In your letter, you state that COMPANY signed a ASoftware Order@ on December 31, 1998, to purchase the software at a cost of $$$$$, with a yearly maintenance and support cost of $$$$$.

The Agreement contains two exhibits representing the software orders. Exhibit A-1 indicates that COMPANY has licensed COMPANY B Software, Version ## for $$$$$ per workstation. COMPANY has licensed this software for ## workstations, for a total cost of $$$$$. In addition, Exhibit A-2 shows that Dental Select has licensed COMPANY B=S Software Version ## PROGRAM Claims Extension Version ##, and PROGRAM Eligibility Extension Version ## for a total cost of $$$$$. The total cost for the software orders is $$$$$.

Exhibit B-1 details five itemized services that Dental Select has purchased from COMPANY B and provides the approximate cost of each service. The first service listed is COMPANY B=s provision of Asoftware installation,@ which is estimated to cost $$$$$. Second, Atraining services@ for COMPANY employees is estimated to cost $$$$$. Third, COMPANY B will provide Aimplementation services,@ which includes business analysis, business implementation services, and product analysis, for an approximate cost of $$$$$. Fourth, COMPANY B will provide Adata conversion services,@ consisting of analyzing COMPANY current system against COMPANY B=s conversion utility format and structure requirement and other related services, for an estimated cost of $$$$$. Fifth, COMPANY B will provide Acustomization services,@ as needed for $$$$$ per hour; however, there is no indication of an estimated cost for this specific service.

Exhibit C-1 contains the support order for the SOFTWARE, with the annual cost of this service to be 15% of the license fee paid for the software. The support order also contains a subsection that entitles COMPANY to receive, without charge, all updates of the SOFTWARE issued by COMPANY B, with Aupdate@ defined to mean a new version of the software product. Exhibit C-2 contains similar provisions that relate to the SOFTWARE.

Canned Versus Custom Software Analysis. Attached to the Agreement is a document titled AModule Functions & Features@ (Page 20). The first sentence of this document proclaims that ASOFTWARE is an application designed specifically for the dental benefits marketplace.@ From this representation, it appears that the copyrighted software that COMPANY purchased is available to a broad marketplace of dental benefits providers. It is not unique software designed exclusively for COMPANY use. Further evidence of this conclusion is COMPANY B=s anticipated creation of new versions of the software (which will be provided free of charge to COMPANY), with the creation of these new versions occurring independently of COMPANY B=s contract with COMPANY. In addition, Exhibits A-1 and A-2 represent COMPANY=S purchase and cost of the copyrighted, mass-marketed software, while any customization work required on the software is indicated separately in Exhibit B-2.

However, you have indicated by telephone that other facts exist which may influence whether the software is considered available to a broad marketplace. First, you indicate that COMPANY B has a history of developing and providing software for hospital billing systems. COMPANY B did not develop the SOFTWARE programs until recently when dental benefit providers began to express a need for such software. In response to the demand, COMPANY B has developed the software product that COMPANY has purchased. A STATE dental benefits company was the first to contract with COMPANY B for the software, and COMPANY is the third company to contract for the product. As of yet, COMPANY B=s dental benefits software system has not been fully implemented and is not in use by any of these contracting customers. While these facts show that the software is new to the marketplace and has not yet been widely sold, they also show that COMPANY B has not produced the software only for use by a particular user. Apparently, COMPANY B=s plan is to mass produce the software and to recoup its development costs not from a single individual user, but from multiple users. That COMPANY is the third customer to purchase the product does not indicate that the software was designed and produced specifically for COMPANY. Instead, this fact suggests otherwise because two dental benefits companies purchased the software prior to COMPANY purchasing it and because the software is available to other dental benefit providers, as well.

In Utah State Tax Commission Advisory Opinion 93-017DJ, the Commission found that software was Acustom@ software in a situation where the software vendor did not inventory any software or mass produce its software. However, in the sale at issue here, COMPANY does apparently mass produce its software for sale to a broad marketplace of dental benefits providers, which would suggest that the software licensed by COMPANY is Acanned,@ not Acustom@ software. You have provided a letter from COMPANY B which lists a number of similarities between the software purchased by COMPANY and the software at issue in Advisory Opinion 93-017DJ. In both instances, the vendor had to conduct a comprehensive analysis of the customer=s objectives and environment, perform extensive data conversions and system adaptations, train the customer=s users, and probably did provide a unique set of services to each client based upon their individual needs. However, the Commission does not consider these other criteria determinative of whether software is Acanned@ or Acustom.@ Instead, the primary consideration is whether the software is mass produced and available to a broad marketplace or whether the software is written specifically for a specific user. Accordingly, the software purchased by COMPANY would be considered Acanned.@

Also, the Commission, in Utah State Tax Commission Advisory Opinion 93-015DJ, provided that computer software was Acanned@ software under these unique circumstances: (1) the customer met with the software provider to identify environment and application requirements; (2) the software provider used a configuration application to specifically identify the customer environment; (3) the licensed program consisted essentially of a set of preexisting routines or programs, although custom routines, while not common, might also be required; and (4) installation was performed by the software provider, including a Afinal tailoring@ to the customer=s specific environment. The Commission determined that the routines were prewritten software prepared for any purchaser, written in conformance to general industry specifications and not those of a particular customer. The Commission recognized that the cost to adapt and configure software to specific customer environments may be costly, but indicated that this fact did not change Asoftware that has been essentially prewritten@ from being considered Acanned@ software. While it is apparent that there are substantial installation, configuration, training, and data conversion costs associated with Dental Select=s licensure of COMPANY B=s software, the existence of these costs does not change a purchase of Acanned@ computer software into a purchase of Acustom@ computer software.

Further, Agreement Exhibits A-1 and A-2 indicate that COMPANY B=S total cost to license the prewritten software is $$$$$. Exhibit B-1 does anticipate possible Acustomization@ services, but does not indicate an estimated cost for this service. Your letter indicates the total purchase price of the software to be $$$$$, which is $$$$$ greater than the $$$$$ required only to license the prewritten software. Even should this entire difference be attributed to customization services, 80% of the total cost would still relate to the prewritten software. Using the Supreme Court sanctioned Aessence of the transaction@ test, a comparison of the proportion of total cost attributable to the prewritten software and the proportion attributable to services indicates that the services provided here are incidental to the purchase of tangible personal property; i.e., the prewritten computer software. For these reasons, COMPANY transaction with COMPANY B is considered a transaction for Acanned@ computer software and is a taxable transaction.

Maintenance Agreement. You have indicated that COMPANY has contracted with COMPANY to provide yearly maintenance and support for a cost of $$$$$ per year. Subsection (B) of Rule 92 provides that charges for software maintenance, consultation in connection with a sale or lease, enhancements, or upgrading of canned or prewritten software are taxable. As the Commission has determined that COMPANY software transaction involves canned or prewritten software, the yearly maintenance and support charges are also taxable.

Customization Services. COMPANY contract does anticipate the need for separate customization services. The cost of these services is $$$$$ per hour of service. Subsection (D) of Rule 92 provides that charges for services to modify or adapt canned computer software or prewritten computer software to a purchaser=s needs or equipment are not taxable if the charges are separately stated and identified. Accordingly, any charges by COMPANY B for service of this type are not taxable if separately stated and identified.

In conclusion, sales and use tax is due on both COMPANY B purchase of software and its purchase of the yearly maintenance and support services. However, charges for customization services are not taxable if separately stated and identified. As to remitting sales and use tax, COMPANY B probably has sales tax nexus with Utah because it will be servicing the software located in Utah. Utah Code Ann. '59-12-107(1)(a)(v). Accordingly, COMPANY B should collect sales tax from COMPANY and remit it to the state of Utah. Should COMPANY B not collect sales tax on the sale, however, COMPANY would still be liable for the tax and should remit it on its own.

For the Commission,

Marc B. Johnson

Commissioner